Among the many other benefits of owning rentals, having the tenant pay down your mortgage and watching the market appreciation increase your value is a wonderful thing. So wonderful that it can then lead to the question about what to do with all of your newfound equity.
For anyone that agrees with the strategy of having good debt, which allows you to borrow dollars from the future at today’s super low interest rates, having a paid off property is not nearly as efficient as one with leverage. Selling is often an idea that is thrown around, though the loss of that income stream and the tax bill can be a downer. Even doing a 1031 exchange has it’s disadvantages, including having to find another replacement property super quick.
I’ve found what I consider to be a meet in the middle solution to the equity “problem.”
Here’s a personal example, back in January I got a $165,000 line of credit against two of my rental properties. It took a week of processing time and 30 minutes of my time updating paperwork. I then used that line of credit to purchase our flip and build project in addition to a private money loan. The line of credit saved me $893 per month in interest (since hard money lenders charge 12% interest) along with $3300 in origination fees. When that project closes at the end of June (crossing my fingers) it will get paid off at closing and we will be ready to go for the next project.
So how did I know I could get a line of credit on those two properties? I pay close attention to what the current market value of these properties are. Not because I’m looking to sell them (they all produce income streams and I want to keep those), but because I want to know when the value gets to a point where I can apply for a line of credit.
You may have heard of the term Home Equity Line of Credit or HELOC before, and in this case I am specifically talking about a line of credit against an investment property.
Using lines of credits to tap into what I call “stagnant equity” has been one of my secrets to success, and one of the strategies I’ve used to acquire rental properties (I have one for $54,500 on one property, and the $165k one on two properties).
Here are the benefits of using lines of credits:
- The IRS still allows a mortgage interest tax deduction, so any interest that is paid on an equity line of credit is a tax deduction.
- Great deals go fast and having a line of credit available when you do find one is huge. I used the line of credit to acquire our latest flip and build project.
- A line of credit allows you to tap into the equity and get the same benefits of selling (access to capital) while not actually having to sell.
- Having access to capital in the form of a line of credit does not require paying any taxes since a sale did not occur. If anything, you are actually saving taxes (see benefit #1).
- When a line of credit is recorded as a mortgage against the property, it looks like you owe the entire balance of the line of credit on the property. This is actually a liability protection against any frivolous lawsuits and lawyers who might be researching your assets to see if it’s worth suing. Check out this Biggerpockets article about other liability protection options.
- You only pay interest on what you use, so if you don’t actually use the line of credit then you’re not paying anything for it. It’s still a good option for a rainy day if something major comes up.
So how do you get a line of credit on an investment property? It’s fairly simple so long as the property meets the guidelines.
First things first, you’ll need to have a relationship with a local bank. I’ve made this point many times, though it’s really important if you are going to want to do any non-traditional loans. An example of a non-traditional loan would be a construction loan, line of credit, business loan or personal loan. If you’re wanting a conventional mortgage you’d be best served by a mortgage broker (do yourself a favor and NEVER even think about using an online lending company). For a car loan, credit unions are fine. For more details on loans read this super long and detailed post.
After you’ve created an account with a small, well capitalized local bank, ask about investment property lines of credit. If you have good credit, experience being a landlord, and enough equity you should be approved.
As far as the equity requirement goes, this is where it can get sticky. Remember, you are asking the bank to give you a loan in second position to the mortgage. Meaning if you stop paying, they are at a higher risk of not getting paid back because the first mortgage will be paid back first. So for the bank to give you a loan in second position, they need to see that you have enough equity in the property.
Typically they will loan you the difference in equity of 70% of value after the first mortgage.
For example, if a property is worth $300,000 and you have a first mortgage of $150,000. 70% of $300,000 is $210,000 which they subtract the first mortgage of $150,000 from and that leaves $60,000 of equity available for a line of credit.
To put it another way, they want to make sure you have 30% of equity in the property after their loan and the first mortgage. It’s really to their benefit and yours.
The bank may require a full appraisal to prove the value, or they may do what’s called a BPO or broker price opinion. This is where the bank pays a real estate agent to do a drive by of the property and do a short report on what that property is worth.
There are pros and cons to both options. The pro for a full appraisal is a more accurate value, which gives you the ability to get a higher loan amount. The downside is they are more expensive, and take longer.
I always go with the BPO option, which is quick and costs $50. I have had times where the agent was way off on value, but it has not affected my ability to get the loan.
Now that we know the benefits and how to get the line of credit, we need to have the “debt conversation.” There are those who think that debt is bad, and there are neither right or wrong, it’s just an opinion. I am adverse to consumer debt, but am of the opposite opinion when it comes to fixed rate debt on cash flowing assets, that comes with tax incentives and can be used to purchase more cash flowing assets.
My best advice would be to do what you think is best for you and what will get you to your goal quicker. I know several investors who use debt to their benefit when in acquisition mode, and use the cash flow of their portfolio to snowball pay it all off in the years before retirement. As you can see, there are many options out there so it’s best to go with your gut.
Since I use debt, I do feel it is necessary to include some details on the discipline side of this strategy. Like anything, moderation is key and having a plan before you get started ensures the best results.
So here are my rules when using lines of credit on investment properties:
I only use lines of credit to acquire more cash flowing properties, not to pay off debt or buy depreciating assets. This is where people can really go wrong. Paying off debt by going into debt is a bad idea in my opinion and can get you further in the hole. This kind of behavior is partially to blame for the last housing crash as people were using properties like ATMs. Depreciating assets are anything that does not go up in value and is worth less after you buy it. Think cars, clothes, electronics, random stuff you probably don’t need.
I require the new property to be able to cash flow with it’s own mortgage, and the line of credit payment. Similar to the above, this is a safety precaution to ensure that you’re not only buying right, but that you’re not putting yourself in a higher debt position and a negative cash flow position at the same time.
Plan to pay off the line of credit as soon as humanly possible. Unlike 30 year fixed mortgages lines of credit are most often a variable rate tied to prime, which means if the prime rate goes up your line of credit interest will too. When I use lines of credit for acquisitions I always pay off the line of credit in less than a year.
I hope this strategy helps you to build your empire!
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